What is a Widow Maker
A widow maker is an extremely risky investment which subjects the investor to very large, potentially devastating loss. In colloquial usage, a widow maker refers to any event with the potential to kill someone quickly. The phrase is an adaptation of one used historically in the forestry and medical industries.
BREAKING DOWN Widow Maker
A widow maker in the financial sense may be just as damaging as it was when used in the forestry and medical industries. Traders apply the phrase to financial investments that involve enough risk to cause catastrophic losses. The use of the term in forestry refers to loose limbs, treetops, or other logging-related materials, lodged overhead, and at risk of falling and killing one or more workers. In medicine, the term implies a blocked artery likely to cause a patient’s death by severe heart attack.
Excessive risk plays a critical role in widow maker trades. As a general rule, investments likely to offer high returns also hold the potential for massive losses. Many investors make decisions about their investments based upon the amount of risk they are willing to take on to achieve a certain level of return. This decision is known as the risk/reward ratio.
Amaranth Death Illustrates Commodity Widow Makers
Commodities experience high price volatility and frequently are thought of as widow makers. Their unpredictable shifts in price could easily wipe out a position, especially when expected future spot prices drift out of alignment with the price of futures contracts. Likewise, the use of leverage, which magnifies both gains and losses on an investment, could generate enough risk to make a trade into a widow maker under the right circumstances.
One of the most famous recent examples of a widow maker trade occurred in natural gas futures. These options track the price on delivery for natural gas at the Henry Hub in Louisiana. Professional traders have long termed the contracts widow makers because of the historic volatility of the cost of natural gas.
In 2006, the Amaranth Traders hedge fund made a massive leveraged trade on natural gas futures, trying to repeat its success on a similar speculative trade made a year earlier. Instead of having a replay of the previous victory, the bottom fell out of the natural gas market, and Amaranth lost $6 billion. This massive loss forced the hedge fund to liquidate its assets.
The energy desk at Amaranth sought higher-than-average rewards by taking on a risky investment prone to unpredictable price changes. Adding leverage to the equation increased that risk further.
Leveraged trades allows an investor to control more shares or contracts than their capital outlay would typically allow. With the offer of potentially higher returns, comes the reality of higher risks.
Wise investors look at highly speculative investments as a gambling venture and mitigate risk accordingly. Risk mitigation strategies might include investing only a small percentage of total assets in the risky investment or implementing trading strategies that limit losses.